Zego Corp. is an all-equity firm and the shareholder’s required rate of return i
ID: 2784531 • Letter: Z
Question
Zego Corp. is an all-equity firm and the shareholder’s required rate of return is 10 percent. Its EBIT is $1,000,000 per year forever and the firm faces a corporate tax rate of 30 percent. Zego now decides to issue $4,000,000 of risk-free debt with an interest rate of 5 percent and use the proceeds to buy back outstanding shares. (i) What is the market value of Zego’s equity before the capital structure change? (ii) What is the value of the tax shields generated by the new debt issue? (iii) What is the total firm value of Zego after the capital structure change?
Explanation / Answer
a.
EBIT of company = $1,000,000
Tax rate = 30%
Net income = $1,000,000 × (1 - 30%)
= $700,000
Net Income of company before capital structure change is $700,000.
Required rate of return = 10%
Unlevered value of firm = $700,000 / 10%
= $7,000,000
Unlevered value of firm is $7,000,000.
b.
Value of tax shield = Value of debt × Tax rate
= $4,000,000 × 30%
= $1,200,000
Value of tax shield is $1,200,000.
c.
Levered value of firm after capital structure change = Unlevered value of firm + Value of tax shield
= $7,000,000 + $1,200,000
= $8,200,000.
Levered value of firm after capital structure change is $8,200,000.
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